Really exciting title, huh? Anyway, several members have asked about this recently, so there are probably more of you out there who are interested.

When you’re constructing an iron condor, it’s nice to be able to just look at the specifics of the trade and have a general notion of the likelihood that it will succeed.  We’re defining “success” as having the underlying fall between your short call and short put at or near expiration, which is the best scenario you can hope for.  The good news is that there’s a really simple formula that will give you a rough idea of this, namely:

Probability of success = real risk / width of spread

Yep, that’s it.  Real risk, for those of you who’ve never read our performance page, is just the width of spread minus the initial credit received.  And the width of the spread is just the distance between the short and long calls or the short and long puts.  So to calculate this formula, you’re simply dividing the real risk by the width of the spread.  Let’s run an example.

For the February trade that we already have on (it’s on SPY, with strikes listed here), we received a credit of $0.67, and the width between the short and long calls is $2.00.  So when we opened the trade, the probability of success was roughly $1.33 / $2.00, or 66.5%.  The word “roughly” is important, because there’s an assumption at work here, which is that options prices at the time we entered the trade were correctly pricing in market volatility.  That’s a pretty safe assumption.  But this is just a rough estimate, so don’t go building a portfolio based solely on it or anything.  Also note that changes in volatility, quite independently of changes in the price of the underlying, can affect the initial credit of the trade and thus the odds of success.

This little formula is pretty useful, because now you can just look at a condor, do the math in your head, and get a sense of how likely it is the trade will succeed given current volatility levels.